Quality of financial position The balance sheet and beyond

[Pages:16]Quality of financial position The balance sheet and beyond

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Assessing the quality of a company's financial position is a complex process. There is no single financial statement that sets forth all of the quantitative and qualitative information reflecting financial position - you must move beyond the balance sheet and perform further analysis to get a complete picture. Although income statements and cash flow statements are important and do provide information relevant to financial position, the balance sheet is a basic "snapshot" of a company's financial position at a particular point in time and is a logical starting point for assessing a company's financial position. The balance sheet delineates the entity's resource structure, or major classes and amounts of assets, as well as its capital structure, or major classes and amounts of liabilities and equity.

Defining quality Many qualitative and quantitative factors that influence a company's financial position may not be obvious from its financial statements. Because there is no single definition of what constitutes a high-quality financial statement, many factors must be reviewed to gain a comprehensive understanding of the strength of a company's financial position. If it is properly prepared and accompanied by appropriate disclosure, the balance sheet gives insight into the following factors, which often differ by company and industry:

? The company's degree of liquidity. Does the company have enough cash, other liquid assets, or credit to pay its obligations promptly? Does the capital structure match the asset structure?

Quality and transparency of financial reporting The transparency of the financial statements and the quality of the financial position are critical in evaluating a company. With the media, analysts, investors, and government leaders all challenging companies' integrity, there is a need for greater transparency in financial reporting, especially given the proliferation of complex, global business structures.

Management and audit committee members need to be champions of these changes. It is imperative that management and external auditors, with appropriate oversight from audit committees, continue to improve financial reporting and communication. One of the key tasks is to gain a better understanding of the assumptions used in establishing significant accounting estimates and determining values. It is also important to understand the company's profile with regard to strategies, objectives, and risk tolerance, and to analyze whether on- or off-balance-sheet transactions involving the company are consistent with that profile. To do this, all parties must take the time to carefully examine the financial statements, including the notes and management's discussion and analysis.

? The nature of the business. What are its inherent risks? Where is there subjectivity? Are the accounting principles and methods appropriate, conservative, or aggressive compared to others in its industry? Are judgments about the selection and method of application of accounting principles based on substance, rather than form?

? The use of historical cost or fair value measurement methods. How great a difference is there between the amounts resulting from the historical cost and fair value methods? To what extent have acquisitions caused a larger portion of the balance sheet to be stated at fair value?

? The estimates and assumptions used in the financial statements. Are the estimates and assumptions reasonable and supportable? Are they determined consistently? Do reserves based on management estimates represent a significant portion of liability or asset valuations?

? The possibility of impairment. Are the company's policies for evaluating impairment reasonable? Do any economic, performance, or industry trends raise questions regarding the ability to recover assets at their recorded amounts?

Quality of Financial Position: The Balance Sheet and Beyond 3

To truly understand a company's financial position, the following factors must be considered in addition to those directly evident in the balance sheet:

liquidity; no matter how much revenue it records, a company still needs cash to pay employees and suppliers and to meet its other obligations.

? The use of off-balance-sheet arrangements. Is there a complete understanding of all significant existing arrangements? Has the company employed structured finance transactions to specifically avoid debt on the balance sheet? How significant are commitments that, by definition, are not obligations on the balance sheet? Have all probable and estimable contingent liabilities been recorded?

? The quality and effectiveness of internal controls. Are there controls in place to safeguard assets and monitor account activities?

The purpose of this document is to assist management and audit committees in working collaboratively with their auditors, advisors, and stakeholders to better assess and communicate the financial position of their companies. It should be noted that although the terms "balance sheet" and "financial position" are often used interchangeably, the focus is on the company's financial position. The concept of financial position extends beyond the balance sheet to encompass a more comprehensive assessment of a company's economic resources, obligations, and equity.

Liquidity Liquidity is one of the most important factors to consider in assessing a company's financial position, and may not be evident in the balance sheet. Liquid assets are cash and other assets that can be easily converted to cash; liquidity is the extent to which an entity can produce cash to meet its obligations. A high degree of liquidity indicates that a company is less likely to fail in the event of a downturn in its business or the economy. A company's growth rate can significantly alter the liquidity needs of the business. A balance sheet with strong liquidity ratios computed on the basis of historical amounts can give false comfort if the company is growing at a fast rate--for example, at 20 or 30 percent. A company needs to prove its ability to achieve profitable growth by emphasizing profits, revenues, and

To achieve a strong financial position, many companies strive to match their capital structure with their asset structure; an example would be to finance shortterm assets with short-term debt or with equity. Understanding the sources of short-term financing and the circumstances that may affect these sources of liquidity is important. If operating cash flows are the principal source of liquidity, consideration should be given to risks that could reduce the availability of those funds. These risks may include fluctuation in customer demand in response to rapid technological changes or the need for funds to reinvest in infrastructure, working capital, or capital expenditures. If commercial paper is a principal source of liquidity, it is important to know how the company could be affected by a downgrade in its debt rating or a deterioration of certain financial ratios or other measures of financial performance. Likewise, it is important to understand the constraints on a company's liquidity in terms of its contractual obligations, such as payments under debt and lease agreements, as well as off-balance-sheet commitments such as debt guarantees.

Although a high level of liquid assets is an indicator of financial flexibility, it comes at a price: cash and cashequivalent assets often produce the lowest returns. Consequently, an entity with a large cash balance may be less profitable than a similar company that has all of its assets invested in profitable business activities.

To distinguish between companies that are truly improving liquidity and those that are seeking shortterm advantage at the risk of long-term consequences, it is important to under-stand the business reasons for transactions. For some businesses or industries, certain transactions, such as sale-lease-backs, factoring of receivables, or transfers of assets to joint ventures, may be outside the ordinary course of business, whereas for other businesses or industries they are part of an ongoing business strategy.

Appendix presents a series of questions that can assist in reviewing information included in a company's balance sheet 4

When analyzing financial position, consideration should be given to norms in the company's industry. For example, most banks and credit card companies are in the business of borrowing and lending, and managing the interest differential between assets and liabilities is a fundamental profit driver. Accordingly, they are debt-heavy by nature. In these cases, one must consider industry-specific metrics of liquidity, such as the credit quality and duration of the loans. A metric of working capital may be appropriate for certain manufacturing or industrial operations, but inappropriate for public utilities that routinely operate with negative working capital.

Another example is a company that finances the sale of its products by extending long-term loans or lease financing to customers as inducements to buy those products. This business model tends to consume capital as inventory is reclassified to long-term assets in the form of receivables rather than being converted to cash. Although this approach is employed successfully by many businesses, it converts inventory risk to credit risk and requires capital in the form of long-term financing to fund the investment in the portfolio.

Consideration should also be given to a company's geographic locations and the risks and rewards related to certain countries. For example, the company's success in certain markets may rely on a particular government leader or access to raw materials and labor.

Restrictions imposed by debt agreements with external lenders are key pressures affecting a company's liquidity. Restrictions can take the form of debt service payments, financial covenants, and borrowing base provisions. Therefore, it is crucial for companies to factor in the effects of these restrictions when projecting liquidity in future periods.

Financial covenants allow lenders to monitor operations and provide remedies to lenders if a company's operations deteriorate. There are two basic types of covenants: qualitative and quantitative. Qualitative covenants ensure that the company maintains its operations in a responsible manner, and include items

such as requiring the company to obtain an unqualified audit report. Quantitative covenants are typically financial ratios and other calculated measures of financial health which companies report to the lenders on a monthly or quarterly basis.

The violation of covenants may expose companies to certain risks. In some cases, lenders will waive a violation for a specific period. In others, lenders may seek to obtain fees for a waiver, restructure operations, or amend the debt agreement. These actions can prove to be very costly to companies, can ultimately result in a loss of management control, and may require the debt to be immediately payable.

Companies with large amounts of current assets (accounts receivable and inventory) sometimes borrow using asset-backed financing. Asset-backed financing gives companies the ability to borrow against the value of the assets, with restrictions as to the overall amount. Operating factors, such as sales fluctuations, receivable collections, production swings, and procurement practices, can cause substantial changes in the base available to borrow against.

In some cases, noncompliance with lender requirements may be the first indication that a company is headed toward financial distress. Once a company is in financial distress, its business can deteriorate quickly. As such, companies should ensure that there are adequate processes in place to forecast cash flows, covenant compliance, and borrowing base levels. Any periods with projected liquidity deficiencies should be identified and addressed in advance.

Financial ratio analysis is another tool for assessing financial position and identifying liquidity benchmarks. To be meaningful, a company's financial ratios for a specific year must be compared to those from prior years to determine trends, and must be compared to industry norms and to those of competitors. Appendix II presents the most common financial ratios used to assess financial position, along with recent average ratios for several major industries.

Quality of Financial Position: The Balance Sheet and Beyond 5

The nature of the business Understanding the nature of a company's business and the inherent risks and subjectivity related to it is important when analyzing financial position. The nature of a company's business depends on many factors, including the size of the company, where the company is in its life cycle, the geographic areas it operates in, and the competitive landscape in which it operates. Normally, there are factors that mitigate the risks, so it is important to understand a company's risk management policies and its strategies. Each company selects accounting policies based on what is appropriate for its business model, and decides how to apply those principles. These decisions can be described as having more or less inherent risk and more or less subjectivity.

The nature of a company's business often dictates the accounting methods under which it operates. Moreover, generally accepted accounting principles (GAAP) often allow alternative methods of accounting for a single

transaction; it is an understanding of both the business and the basis for the selection that provides insight into the company's financial position.

The accounting policies footnote to the financial statements and management's discussion and analysis help summarize a company's accounting methods and assumptions. The regulator has recognized the importance of disclosing critical accounting policies as an aid to investors' understanding.

The accompanying table provides examples of the degree of inherent risk and subjectivity related to the nature of a company's business and examples based on the application of alternative accounting principles. All of these factors, whether the result of management decisions or industry norms, shape a company's financial position and should be considered in assessing its quality.

Less

Inherent risk subjectivity

More

Characteristic Diversified customer base; creditworthy customers; short-term receivables; fairly current balances

Consistently using a formula, with larger percentages applied to older aging categories based on collection history; using specific reserves for accounts in dispute or in situations where collectability is in question

Expensed as incurred, when permitted under GAAP

Investment in securities that are more liquid; diversification; accepting lower yield in exchange for higher quality

Used to mitigate business risk (e.g., clearly defined hedging and risk management policies monitored through effective controls, such as an interest rate swap used in a hedging relationship)

Adequate supply of inventory on hand, resulting in a high turnover rate

Account Accounts Receivable

Accounts receivable ? allowance for doubtful accounts Prepaid expenses Investment securities Derivatives

Inventory

Characteristic Concentration in a single or a few customers; customers with questionable credit; long-term receivables; older balances; related-party receivables

Reserve calculated based on judgment and historical write-offs; use of a flat percentage for all aging categories

Capitalizing and amortizing expenses whenever possible

Investment in securities that are less liquid; concentration of investments; seeking higher yield at greater risk

Used to create profit opportunity (e.g., speculative trading, such as an option on a volatile equity security)

Excessive supply of inventory on hand, resulting in a low turnover rate

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Less

Inherent risk subjectivity

More

Characteristic

Account

Accelerated method; lower residual estimate; realistic useful lives for individual items based on historical data and known trends

Fixed assets ? depreciation method

Characteristic

Straight-line method; greater residual estimate; generalized useful lives without historical basis or trends; minimal correlation between the method and the usage

Lower expected rate of return; lower assumed discount Pension plan assets and obligations rate

Higher expected rate of return; higher assumed discount rate

Conservative future cash flow and fair value assumptions; realistic remaining useful lives

Impairment ? fixed assets; intangibles Aggressive future cash flow and fair value assumptions; unrealistic remaining useful lives

Reserves calculated by third parties (e.g., self-insurance Other accruals ? litigation, environ-

reserve estimated by actuaries)

mental, warranties

Reserves calculated by management using a historical basis

Reserve calculation based on history, known problems Loan loss accruals in the portfolio, the quality of the portfolio, and current economic conditions

Reserve based on management judgment and comparison with peers

Fair-value-based method of accounting for stock options

Minimal debt covenants; absence of other-than-customary default triggers or cross-default provisions

Compensatory stock option plans Long-term debt

Intrinsic-value-based method of accounting for stock options

Highly restrictive debt covenants, particularly those based on multiple financial ratios; accelerated debt payments in the event of a credit downgrade, default, or other event trigger; redemption required at a significant premium as a result of certain events (e.g., change of control)

Non-redeemable preferred stock with a fixed dividend rate; convertible preferred stock into fixed number of common shares

Equity ? preferred stock

Preferred stock containing a fixed maturity date or mandatory redemption feature which is not within the control of the issuer; nonredeemable preferred stock (no maturity date) that contains a cash/put feature

Settlement in a fixed number of shares

Traditional, simplistic financial structures; traditional two-step securitization structure used for monetizing traditional asset classes (e.g., auto loans, mortgages, credit cards)

Put/call features (on preferred stock, warrants, etc.)

Special-purpose entities

Settlement in cash (would result in derivative accounting); contingent on defined events

Nontraditional, complex structures; monetizing nontraditional asset classes (e.g., inventory, fixed assets); use of minimal outside equity in the structures to achieve off-balance-sheet treatment

Conservative estimated future tax effects attributable to temporary differences and carry-forwards

Deferred tax liability or asset

Aggressive estimated future tax effects attributable to temporary differences and carryforwards

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Proximity of book values to economic fair values Accounting standard-setters are moving toward creating a fair value balance sheet in their efforts to support quality of financial position. This increased use of fair value accounting rather than historical cost accounting on the balance sheet has added another important dimension to the assessment of a company's financial position. It is not only derivatives that require a close look, but also the valuation of stock options, warrants, securitization gains, and a variety of other mark-tomarket issues. The quality of the fair value estimates is influenced by the reasonableness of the assumptions used and the quality of the experts and the models on which the estimates rely. Valuations that are easily determined and readily realized, such as in an active market are more reliable than those that rely on private valuation approaches based on models. Private valuations are necessary for contracts that may be indexed to measures of weather; commodities process; or quoted prices of service capacity, such as energy storage and bandwidth contracts. For example, the value of a 10-year Treasury bond can be determined from public sources, but the value of a 20-year energy contract needs to be benchmarked against a model reflecting similar contracts. Modeling has inherent uncertainties, for example, in the case of a 20-year energy contract there may be relatively few trades of similar instruments.

Despite attempts to increase the amount of fair value reporting on the balance sheet, there are still many assets and liabilities that are valued based on historical costs that are significantly different than fair values. An example is land, which may have increased in value since the time of its purchase. The most common means of bringing this value onto the balance sheet is to sell the asset and make it liquid, or to revalue it in an acquisition. Consequently, it is important to know if there have been any recent acquisitions, which would increase the proximity of fair value and historical cost.

In assessing financial position, consideration should also be given to any changes in fair value attributable to altered valuation techniques. For example, it is important to understand how the company manages the risks related to changes in credit quality or market fluctuations of underlying, linked, or indexed assets or liabilities, especially when those assets are illiquid or susceptible to material uncertainties in valuation.

Considerable attention is being given to fair value accounting. A recent accounting pronouncement requires companies to reassess their recorded goodwill and other intangibles and the useful lives of these assets to achieve closer alignment with fair values. Additionally, the book values of many assets on the balance sheet differ from the values that would be recorded by the purchaser if the company were sold. Accounting principles require the write-down of overvalued assets, but there is no provision to increase many undervalued assets. Understanding the fair value of a company's assets and liabilities as compared to their recorded value provides insight into the company's financial position.

Estimates and assumptions There are areas of judgment that require management to make and record estimates in their financial statements. Among these areas are estimates of pension, health care, and post-retirement medical assets and liabilities. Judgment is also involved in determining allowances and reserves for a variety of items, including the collectability of receivables and loans; the utility, value, or obsolescence of inventory; the realization of deferred tax assets; and environmental, plant closing, warranty, and self-insurance reserves. These assets and liabilities are subject to estimates of recoverability or valuation, and it is important to understand the quality of the underlying estimates and the assumptions used in developing them. It is also important to understand the portion of the estimates that is based on management's assumptions. The use of third-party specialists can improve the quality of estimates and assumptions, especially in the areas of pension and benefit plan valuations, derivatives valuations, and litigation and environmental reserves.

Some areas require more judgment than others; for example, pension accounting relies on the assumptions of management and plan actuaries. Companies sponsor pension plans and incur pension obligations--the assumed future obligation to retired employees. In the long term, pension plan assets and investment returns reduce those liabilities. In the short term, if the fund's returns are projected to exceed the expected liability and associated costs, the company's pension contribution can be reduced, which can boost earnings. The higher the expected rate of return the lower the company's pension expense, resulting in greater earnings.

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